Beginners’ Guide to Asset Allocation, Diversification,
and Rebalancing
Even if you are new to investing, you may already know
some of the most fundamental principles of sound
investing. How did you learn them? Through ordinary,
real-life experiences that have nothing to do with the
stock market.
For example, have you ever noticed that street vendors
often sell seemingly unrelated products - such as um-
brellas and sunglasses? Initially, that may seem odd.
After all, when would a person buy both items at the
same time? Probably never - and that’s the point. Street
vendors know that when it’s raining, it’s easier to sell
umbrellas but harder to sell sunglasses. And when it’s
sunny, the reverse is true. By selling both items - in oth-
er words, by diversifying the product line - the vendor
can reduce the risk of losing money on any given day.
If that makes sense, you’ve got a great start on un-
derstanding asset allocation and diversification. This
publication will cover those topics more fully and will
also discuss the importance of rebalancing from time to
time.
Let’s begin by looking at asset allocation.
Asset Allocation 101
Asset allocation involves dividing an investment port-
folio among different asset categories, such as stocks,
bonds, and cash. The process of determining which mix
of assets to hold in your portfolio is a very personal one.
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The asset allocation that works best for you at any given
point in your life will depend largely on your time hori-
zon and your ability to tolerate risk.
Time Horizon
Your time horizon is the expected number of
months, years, or decades you will be invest-
ing to achieve a particular financial goal. An
investor with a longer time horizon may feel
more comfortable taking on a riskier, or more
volatile, investment because he or she can wait
out slow economic cycles and the inevitable
ups and downs of our markets. By contrast,
an investor saving up for a teenager’s college
education would likely take on less risk be-
cause he or she has a shorter time horizon.
Risk Tolerance
Risk tolerance is your ability and willingness
to lose some or all of your original investment
in exchange for greater potential returns. An
aggressive investor, or one with a high-risk
tolerance, is more likely to risk losing money
in order to get better results. A conservative
investor, or one with a low-risk tolerance,
tends to favor investments that will preserve
his or her original investment. In the words of
the famous saying, conservative investors keep
a “bird in the hand,” while aggressive investors
seek “two in the bush.”
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Risk versus Reward
When it comes to investing, risk and reward are inex-
tricably entwined. You’ve probably heard the phrase “no
pain, no gain” - those words come close to summing
up the relationship between risk and reward. Don’t let
anyone tell you otherwise. All investments involve some
degree of risk. If you intend to purchase securities -
such as stocks, bonds, or mutual funds - it’s important
that you understand before you invest that you could
lose some or all of your money.
The reward for taking on risk is the potential for a great-
er investment return. If you have a financial goal with a
long time horizon, you are likely to make more money
by carefully investing in asset categories with greater
risk, like stocks or bonds, rather than restricting your
investments to assets with less risk, like cash equivalents.
On the other hand, investing solely in cash investments
may be appropriate for short-term financial goals.
Investment Choices
While the SEC cannot recommend any particular in-
vestment product, you should know that a vast array of
investment products exists - including stocks and stock
mutual funds, corporate and municipal bonds, bond
mutual funds, lifecycle funds, exchange-traded funds,
money market funds, and U.S. Treasury securities.
For many financial goals, investing in a mix of stocks,
bonds, and cash can be a good strategy. Let’s take a
closer look at the characteristics of the three major asset
categories.
Stocks
Stocks have historically had the greatest risk
and highest returns among the three major as-
set categories. As an asset category, stocks are a
portfolio’s “heavy hitter,” offering the greatest
potential for growth. Stocks hit home runs,
but also strike out. The volatility of stocks
makes them a very risky investment in the
short term. Large company stocks as a group,
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for example, have lost money on average about
one out of every three years. And sometimes
the losses have been quite dramatic. But inves-
tors that have been willing to ride out the
volatile returns of stocks over long periods of
time generally have been rewarded with strong
positive returns.
Bonds
Bonds are generally less volatile than stocks
but offer more modest returns. As a result, an
investor approaching a financial goal might
increase his or her bond holdings relative to
his or her stock holdings because the reduced
risk of holding more bonds would be attractive
to the investor despite their lower potential for
growth. You should keep in mind that certain
categories of bonds offer high returns similar
to stocks. But these bonds, known as high-
yield or junk bonds, also carry higher risk.
Cash
Cash and cash equivalents - such as savings
deposits, certificates of deposit, treasury bills,
money market deposit accounts, and money
market funds - are the safest investments, but
offer the lowest return of the three major asset
categories. The chances of losing money on
an investment in this asset category are gener-
ally extremely low. The federal government
guarantees many investments in cash equiva-
lents. Investment losses in non-guaranteed
cash equivalents do occur, but infrequently.
The principal concern for investors investing
in cash equivalents is inflation risk. This is
the risk that inflation will outpace and erode
investment returns over time.
Stocks, bonds, and cash are the most common asset
categories. These are the asset categories you would
likely choose from when investing in a retirement sav-
ings program or a college savings plan. But other asset
categories - including real estate, precious metals and
other commodities, and private equity - also exist, and
some investors may include these asset categories within
a portfolio. Investments in these asset categories typi-
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cally have category-specific risks. Before you make any
investment, you should understand the risks of the
investment and make sure the risks are appropriate for
you.
Why Asset Allocation Is So Important
By including asset categories with investment returns
that move up and down under different market condi-
tions within a portfolio, an investor can protect against
significant losses. Historically, the returns of the three
major asset categories have not moved up and down at
the same time. Market conditions that cause one asset
category to do well often cause another asset category to
have average or poor returns. By investing in more than
one asset category, you’ll reduce the risk that you’ll lose
money and your portfolio’s overall investment returns
will have a smoother ride. If one asset category’s invest-
ment return falls, you’ll be in a position to counteract
your losses in that asset category with better investment
returns in another asset category.
The Magic of Diversification
The practice of spreading money among different
investments to reduce risk is known as diversifica-
tion. By picking the right group of investments,
you may be able to limit your losses and reduce
the fluctuations of investment returns without
sacrificing too much potential gain.
In addition, asset allocation is important because it has
a major impact on whether you will meet your financial
goal. If you don’t include enough risk in your portfolio,
your investments may not earn a large enough return
to meet your goal. For example, if you are saving for
a long-term goal, such as retirement or college, most
financial experts agree that you will likely need to in-
clude at least some stock or stock mutual funds in your
portfolio. On the other hand, if you include too much
risk in your portfolio, the money for your goal may not
be there when you need it. A portfolio heavily weighted
in stock or stock mutual funds, for instance, would be
inappropriate for a short-term goal, such as saving for a
family’s summer vacation.
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How to Get Started
Determining the appropriate asset allocation model for
a financial goal is a complicated task. Basically, you’re
trying to pick a mix of assets that has the highest prob-
ability of meeting your goal at a level of risk you can live
with. As you get closer to meeting your goal, you’ll need
to be able to adjust the mix of assets.
If you understand your time horizon and risk tolerance
- and have some investing experience - you may feel
comfortable creating your own asset allocation model.
“How to” books on investing often discuss general
“rules of thumb,” and various online resources can help
you with your decision. For example, although the SEC
cannot endorse any particular formula or methodology,
the Iowa Public Employees Retirement System (www.
ipers.org) offers an online asset allocation calculator. In
the end, you’ll be making a very personal choice. There
is no single asset allocation model that is right for every
financial goal. You’ll need to use the one that is right for
you.
Some financial experts believe that determining your
asset allocation is the most important decision that
you’ll make with respect to your investments - that it’s
even more important than the individual investments
you buy. With that in mind, you may want to consider
asking a financial professional to help you determine
your initial asset allocation and suggest adjustments for
the future. But before you hire anyone to help you with
these enormously important decisions, be sure to do a
thorough check of his or her credentials and disciplinary
history.
The Connection Between Asset Allocation
and Diversification
Diversification is a strategy that can be neatly summed
up by the timeless adage, “don’t put all your eggs in one
basket.” The strategy involves spreading your money
among various investments in the hope that if one in-
vestment loses money, the other investments will more
than make up for those losses.
Many investors use asset allocation as a way to diver-
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sify their investments among asset categories. But other
investors deliberately do not. For example, investing
entirely in stock, in the case of a twenty-five year-old
investing for retirement, or investing entirely in cash
equivalents, in the case of a family saving for the down
payment on a house, might be reasonable asset alloca-
tion strategies under certain circumstances. But neither
strategy attempts to reduce risk by holding different
types of asset categories. So choosing an asset allocation
model won’t necessarily diversify your portfolio. Wheth-
er your portfolio is diversified will depend on how you
spread the money in your portfolio among different
types of investments.
Diversification 101
A diversified portfolio should be diversified at two levels:
between asset categories and within asset categories.
So in addition to allocating your investments among
stocks, bonds, cash equivalents, and possibly other asset
categories, you’ll also need to spread out your invest-
ments within each asset category. The key is to identify
investments in segments of each asset category that may
perform differently under different market conditions.
One way of diversifying your investments within an
asset category is to identify and invest in a wide range of
companies and industry sectors. But the stock portion
of your investment portfolio won’t be diversified, for
example, if you only invest in only four or five individ-
ual stocks. You’ll need at least a dozen carefully selected
individual stocks to be truly diversified.
Because achieving diversification can be so challenging,
some investors may find it easier to diversify within each
asset category through the ownership of mutual funds
rather than through individual investments from each
asset category. A mutual fund is a company that pools
money from many investors and invests the money in
stocks, bonds, and other financial instruments. Mutual
funds make it easy for investors to own a small portion
of many investments. A total stock market index fund,
for example, owns stock in thousands of companies.
That’s a lot of diversification for one investment!
Be aware, however, that a mutual fund investment
doesn’t necessarily provide instant diversification, espe-
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cially if the fund focuses on only one particular indus-
try sector. If you invest in narrowly focused mutual
funds, you may need to invest in more than one mutual
fund to get the diversification you seek. Within asset
categories, that may mean considering, for instance,
large company stock funds as well as some small com-
pany and international stock funds. Between asset cat-
egories, that may mean considering stock funds, bond
funds, and money market funds. Of course, as you add
more investments to your portfolio, you’ll likely pay
additional fees and expenses, which will, in turn, lower
your investment returns. So you’ll need to consider
these costs when deciding the best way to diversify your
portfolio.
Options for One-Stop Shopping- Lifecycle
Funds
To accommodate investors who prefer to use one
investment to save for a particular investment
goal, such as retirement, some mutual fund com-
panies offer a product known as a “lifecycle fund.”
A lifecycle fund is a diversified mutual fund that
automatically shifts towards a more conservative
mix of investments as it approaches a particular
year in the future, known as its “target date.” A
lifecycle fund investor picks a fund with the right
target date based on his or her particular invest-
ment goal. The managers of the fund then make
all decisions about asset allocation, diversification,
and rebalancing. It’s easy to identify a lifecycle
fund because its name will likely refer to its target
date. For example, you might see lifecycle funds
with names like “Portfolio 2015,” “Retirement
Fund 2030,” or “Target 2045.”
Changing Your Asset Allocation
The most common reason for changing your asset allo-
cation is a change in your time horizon. In other words,
as you get closer to your investment goal, you’ll likely
need to change your asset allocation. For example, most
people investing for retirement hold less stock and
more bonds and cash equivalents as they get closer to
retirement age. You may also need to change your asset
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allocation if there is a change in your risk tolerance,
financial situation, or the financial goal itself.
But savvy investors typically do not change their asset
allocation based on the relative performance of asset
categories - for example, increasing the proportion of
stocks in one’s portfolio when the stock market is hot.
Instead, that’s when they “rebalance” their portfolios.
Rebalancing 101
Rebalancing is bringing your portfolio back to your
original asset allocation mix. This is necessary because
over time some of your investments may become out of
alignment with your investment goals. You’ll find that
some of your investments will grow faster than others.
By rebalancing, you’ll ensure that your portfolio does
not overemphasize one or more asset categories, and
you’ll return your portfolio to a comfortable level of
risk.
For example, let’s say you determined that stock invest-
ments should represent 60% of your portfolio. But
after a recent stock market increase, stock investments
represent 80% of your portfolio. You’ll need to either
sell some of your stock investments or purchase invest-
ments from an under-weighted asset category in order
to reestablish your original asset allocation mix.
When you rebalance, you’ll also need to review the
investments within each asset allocation category. If any
of these investments are out of alignment with your
investment goals, you’ll need to make changes to bring
them back to their original allocation within the asset
category.
There are basically three different ways you can rebal-
ance your portfolio:
1. You can sell off investments from over-weighted
asset categories and use the proceeds to purchase
investments for under-weighted asset categories.
2. You can purchase new investments for under-
weighted asset categories.
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3. If you are making continuous contributions to the
portfolio, you can alter your contributions so that
more investments go to under-weighted asset cat-
egories until your portfolio is back into balance.
Before you rebalance your portfolio, you should consid-
er whether the method of rebalancing you decide to use
will trigger transaction fees or tax consequences. Your fi-
nancial professional or tax adviser can help you identify
ways that you can minimize these potential costs.
Stick with Your Plan:
Buy Low, Sell High - Shifting money away from
an asset category when it is doing well in favor
an asset category that is doing poorly may not be
easy, but it can be a wise move. By cutting back
on the current “winners” and adding more of the
current so-called “losers,” rebalancing forces you
to buy low and sell high.
When to Consider Rebalancing
You can rebalance your portfolio based either on the
calendar or on your investments. Many financial ex-
perts recommend that investors rebalance their port-
folios on a regular time interval, such as every six or
twelve months. The advantage of this method is that
the calendar is a reminder of when you should consider
rebalancing.
Others recommend rebalancing only when the relative
weight of an asset class increases or decreases more than
a certain percentage that you’ve identified in advance.
The advantage of this method is that your investments
tell you when to rebalance. In either case, rebalancing
tends to work best when done on a relatively infrequent
basis.
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Where to Find More Information Questions or Complaints?

For more information on investing wisely and avoiding
costly mistakes, please visit the Investor Information
section of the SEC’s website. You also can learn more
about several investment topics, including asset alloca-
tion, diversification and rebalancing in the context of
saving for retirement by visiting FINRA’s Smart 401(k)
Investing website as well as the Department of Labor’s
Employee Benefits Security Administration website.
You can find out more about your risk tolerance by
completing free online questionnaires available on
numerous websites maintained by investment publica-
tions, mutual fund companies, and other financial pro-
fessionals. Some of the websites will even estimate asset
allocations based on responses to the questionnaires.
While the suggested asset allocations may be a useful
starting point for determining an appropriate allocation
for a particular goal, investors should keep in mind that
the results may be biased towards financial products or
services sold by companies or individuals maintaining
the websites.
We want to hear from you if you encounter a problem
with a financial professional or have a complaint con-
cerning a mutual fund or public company. Please send
us your complaint using our online Complaint Center.
You can also reach us by regular mail at:
Securities and Exchange Commission
Office of Investor Education and Assistance
100 F Street, N.E.
Washington, D.C. 20549-0213
www.sec.gov
The Office of Investor Education and Advocacy
has provided this information as a service to
investors. It is neither a legal interpretation nor
a statement of SEC policy. If you have ques-
tions concerning the meaning or application of
a particular law or rule, please consult with an
attorney who specializes in securities law.

Once you’ve started investing, you’ll typically have ac-

cess to online resources that can help you manage your
portfolio. The websites of many mutual fund compa-
nies, for example, give customers the ability to run a
“portfolio analysis” of their investments. The results
of a portfolio analysis can help you analyze your asset
allocation, determine whether your investments are
diversified, and decide whether you need to rebalance
your portfolio.

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